1

Chapter 12 The Financial Collapse of

2007 - 2008

These slides supplement the textbook, but should not replace reading the textbook

2

What is the main point of Frederick Hayek’s 1944 book

The Road to Serfdom?

The loss of personal freedom comes when planners realize that the only way for the plan to work is to mandate that everyone adhere to the plan

3

What is the main point of Philip Howard’s 2014 book

The Rule of Nobody?

Rules are replacing basic principles and with the proliferation of arcane rules and lengthy and complex regulations, individual freedom is destroyed

4

Why is Growth important?

If we do not grow there is less goods and services as things deteriorate over time

5

Where do we begin?

free markets / planned economy

The role of government

6

Does the Keynesian policy of increasing

government spending lead to more growth or

less growth?Keynesians believe that it

increases growth by shifting the aggregate demand curve to a full employment equilibrium

7

According to Keynesians why does an increase in

borrowing and government spending lead to growth?

The Keynesian multiplier supports the idea that when people have a dollar they will save some of it, but if the government has the dollar it will spend all of it

8

What is the main objection that Austrian Economists have against Keynesians?

The Keynesian emphasis on government borrowing and spending impede growth because it works at cross purposes to saving, investing and supply

9

According to Austrians why does an increase in

government spending lead to less growth?

• Higher taxes• More debt• More regulations• Diminishes private investments• Choices made because of

politics rather than economics

10

What is the upshot to the story of our

financial collapse of 2007-2008?

Policies of the federal government and the Federal Reserve distorted markets

11

Why is excessive debt a problem in an economic

downturn?

People cannot meet their debt obligations and a dominoes affect sets in

12

What is a Security?A financial instrument

representing financial value such as mortgages, bonds, banknotes, stocks, future contracts, and derivatives

13

What does Securitizing Debts Mean?

The financial practice of pooling debts, like mortgages, and selling the consolidated debts as bonds (securities) which pay the investors principle and interest regularly

14

What is the Purpose of Securitizing Debts?Its purpose is to allow

lenders to reinvest their assets into more lending and in affect increase the number of lenders in the mortgage market

15

What is a Collaterized Debt Obligation (CDO)?A type of structured asset

whose value and payments are derived from a portfolio of fixed income assets, it is a collection of streams of income under one roof

16

How are CDOs structured?

Hundreds of loans are put into a pool and then divided into different tranches according to risk level

17

What gives CDOs value?

The money that flows into and out of the CDO as people pay their monthly installment loans or retire the loans

18

Show me how collateralized debt obligations work

http://www.khanacademy.org/finance-economics/core-finance/v/collateralized-debt-obligation-overview

19

What is the purpose of Fannie Mae?

Its purpose is to expand the secondary mortgage market by securitizing mortgages in the form of mortgage backed securities (MBS)

20

What is Freddie Mac?

Authorized by Congress in 1972 to purchase private mortgages on the secondary market to compete with Fannie Mae

21

What are some problems with

securitizing debt?The complexity can limit

investors ability to monitor risk, and make it more difficult to standardize the market

22

What is leverage?

The act of using borrowed money to make bets on some future event

23

What is aSubprime Mortgage?

A type of mortgage which involved a high level of risk to the lender and in some cases actual deceit and fraud

24

What is an Alt-A Loan?

Sometimes called “Liar Loans” they required less documentation than traditional subprime loans

25

What was the policy of Alan Greenspan, chair of the Fed from 1987-2006?The easy-money policies of

the Fed during Greenspan's tenure has been suggested to be a leading cause of the subprime mortgage crisis

26

Why were the easy money policies of the

Fed a factor in the mortgage crises?

People borrowed money to buy homes, the price of homes increased, equity increased, and many people borrowed against the home’s equity

27

What is the Housing and Community Development

Act of 1977?Banks were required to make

substantial loans to low income persons even with bad credit ratings

28

Why did Fan and Fred defraud investors?

To increase market share in the subprime loan market and to meet the demands of the Housing and Community Development Act of 1977

29

What is the Housing and Community Development

Act of 1992?Fannie Mae and Freddie Mac

were required to meet a goal of 30% mortgages bought should be from low and moderate income families, raised to 55% in 2007

30

What pressure was put on Fannie Mae in 1999?The Clinton Administration

encouraged an increase in loan purchases stemming from inner city areas and pressed for an easing of standards in the primary mortgage market

31

What mandates were put on Fannie Mae and Freddie Mac in 2004?

They were required to purchase subprime loans from banks to the tune of about $1 billion per week

32

What is the Securities and Exchange

Commission (SEC)?This commission is responsible

for enforcing the federal securities law and regulating the securities industry

33

What did the SEC do in 2004 that effected the

securities market?It allowed banks to set their

own “debt-to-net-capital rule” which changed the industry standard from a 12 to 1 debt capital ratio to 40 to 1 ratio

34

Which firms benefited the most from this

change in legal ratios?• Goldman Sachs• Bear Stearns• Morgan Stanley• Merrill Lynch• Lehman Brothers

35

What happened in 2008 to these investment banks?

They all collapsed and either disappeared or were converted to bank holding companies so they could be bailed out by the Fed

36

What is the Private Securities Litigation

Act of 1995?This act protected Wall Street

firms from legal suits and restricted investors from suing banks for fraud

37

What was the result of the secondary

mortgage market and the Private Securities

Litigation Act of 1995?They gave banks and mortgage

related companies a free hand to engage in high levels of speculation and fraud

38

Who is Angelo Mozilo and what is Country

Wide Mortgage?Angelo Mozilo founded

Country Wide, a mortgage company that specialized in subprime mortgages

39

What role did Country Wide Home Loans play?

Country Wide, partnered with Fannie and formed a reduced documentation loan program, Country Wide found the customers and Fan provided the money

40

What is the Financial Crises Inquiry Commission?

A Congressional commission that spent 18 months investigating the subprime mortgage problem and in 2011 found Fan and Fred innocent of any fault and blamed the crises on private bankers

41

What is the lawsuit that the SEC brought

against Fannie and Freddie in 2012?

The SEC claims that six Fan and Fred executives defrauded investors because they knew and approved misleading statements about their subprime loan exposure

42

What is an example of Hedging?

A farmer agrees to sell his corn to someone at a set price on a set date in the future

43

What is an Option?A derivative financial

instrument that specifies a contract between two parties for a future transaction on an asset at a reference price (the strike price)

44

What are the two types of Options?

An option to buy something at a specific price in the future is named a “call”; an option to sell something at a specific price is named a “put”

45

What does it mean to Short the Stock Market?You borrow shares from a

brokerage house in order to sell them in the hope that you can buy them later at a lower price, you gain when the price declines and lose when the price increases

46

What is a Hedge Fund?A private investment fund which

may invest in a diverse range of assets and may employ a variety of investment strategies to protect from downturns and maximize the market upswings

47

What is aDerivative Instrument?

A contract between two parties that specifies conditions under which payments are to be made between the two parties

48

What is aDerivatives Market?

A financial market for future contracts, these financial instruments in a futures market are called options

49

What is aFutures Market?

A specific type of derivative involving a bet between two parties on the future price, called the strike price, of some specified standardized product, like the price of corn six months from the agreement

50

How is Future Value Determined?

Derivatives often rely on some complicated mathematical model to determine future value, like the Black - Scholes model

51

What is an example of Speculative Trading in

the Derivatives Market?In 1995 Nick Leeson, a

trader for Barings Bank, the oldest investment bank in London, made poor and unauthorized investments in futures contracts bankrupting the bank

52

What is anOver-the-Counter

Derivatives Market?A market that is an agreement

between two parties and no one else, the contract is personal between the two parties, there is no exchange where information is shared

53

Is it possible that even the purchaser of the derivative is not privy to the facts?

Yes, investment companies like Bear Stearns often sold contracts to others, like pension funds, without divulging all the facts

54

How large is the Derivatives Market today?

The notional value, the hypothetical value existing only in theory, is about $600 trillion!!!

55

What is the Commodity Futures Trading

Commission (CFTC)?

Authorized to regulate agricultural futures and the derivatives market

56

Who is Brooksley Born?

She was the head of the Commodity Futures Trading Commission from August 1996 to June 1999

57

What did Brooksley Born do as head of the CFTC?She lobbied Congress and the President to give the CFTC oversight of the over-the-counter derivatives market

58

Why was Brooksley Born concerned ?

Dangerous things were happening in the market like fraud and excessive speculation leading to major failures

59

What was the event that brought these excesses to light?

In 1996 Proctor and Gamble ended up owing $200 billion in the derivatives market and it sued their derivatives dealer, Bankers Trust, for fraud claiming it was not given proper explanation

60

What was the outcome between

Proctor and Gamble and Bankers Trust?

In 1996 Bankers Trust settled with Proctor and Gamble forgiving most of the debt

61

What happened after Brooksley Born

alerted the Treasury, the Fed, and the SEC about her concern?She was relieved of her

jurisdiction over the derivatives market

62

Who is Alan Greenspan?

He was Chairman of the Fed from 1987 to 2006

63

Who was Ayn Rand (1905-1982)?

She was a playwright, screenwriter, and author who wrote The Fountainhead (1943) and Atlas Shrugged (1957)

64

What was Ayn Rand’s philosophy?

She believed in a strict laissez faire capitalistic economic system with minimal government and where rational self-interest plays a key role

65

Who was Atlas in Greek mythology?

He was a god who held the world on his shoulders

66

Who was Atlas in her book Atlas Shrugged?The entrepreneur, when he

shrugs the whole world comes tumbling down

67

How did Ayn Rand influence Alan Greenspan?

He was her protégé and close friend

68

What was Alan Greenspan’s response

to Brooksley Born?

He believed that the free market would take care of all problems and that any interference in the market would be harmful

69

What happened to Long Term Capital in

1998?Long Term Capital, a hedge

fund, was highly leveraged in the derivatives market with $1.25 trillion notional value with only $4 billion capital to back it up

70

What happened to Long Term Capital?

In 1998 big banks stepped in and took over Long Term Capital and incurred large losses on its leveraged investments

71

What is the Commodity Futures Modernization

Act of 2000?

This act stripped the Commodity Futures Trading Commission of all responsibility over the derivatives market

72

What did the Modernization Act do ?It forbid state regulators to

interfere with the over-the-counter derivatives market

73

What did rent seeking have to do with the

situation between 2000 and 2010?

Wall Street firms plied over $1.7 billion in campaign contributions and $3.4 billion on lobbyists

74

What was the Glass-Steagall Act of 1932 ?

This act separated commercial banking from investment banking, commercial banks were regulated and investment banks were not

75

What happened to the Glass-Steagall Act?

The Commodity Futures Modernization Act of 2000 obliterated the difference between commercial banks and investment banks

76

What else did the Modernization Act of

2000 do?The FDIC granted the

same protection to investment banks as they did to commercial banks

77

What is a Credit Default Swap?

A CDS is a bet on a future event involving a hedge against a possible default, for a price it transfers liability on an investment from party A to party B

78

When did CDSs emerge?

In 1994 when young executives from JP Morgan bank had a weekend meeting in Boca Raton Florida

79

What is the American International Group (AIG)?

AIG is an American insurance corporation who in 2008 was the 18th largest public company in the world

80

What is an example of a CDS?

Bank A lends one million dollars to the XYZ company and then pays AIG to take the risk of a possible default

81

What effect did a bank’s CDS have on its

excess reserves?The Fed agreed to lower its

reserve requirement because of the lower risk incurred by banks

82

What is Standard and Poor’s and Moody’s?

How do they get paid?

Two credit rating agencies – They are paid by the companies they rate

83

What role did these agencies play in the financial collapse of

2007-2008?Because AIG sold CDSs to

CDOs and AIG had a triple A credit rating, the whole CDO was given a triple A rating

84

Who is Joe Cassano?

Between 2001 and 2008 he was the head of the Financial Products Division of AIG

85

What did Joe Cassano do?

He sold billions of dollars worth of CDSs to banks without the assets to back up the insurance

86

What is a Naked CDS?In a naked CDS neither party

actually holds the underlying loan, in essence two non-involved parties make a bet on some future event

87

How did Joe Cassano use Naked CDSs?

He sold CDSs protection to numerous non-involved banks on the same loan

88

What precipitated the Financial Bubble in 2000?

• Fed policies• Deregulation mania• Excessive leverage

89

What is an Adjustable Rate Mortgage Loan?

The interest rate would increase over time according to a pre-determined schedule

90

What does it mean to be Upside Down on a

Mortgage?

You owe more on a house than what the house is worth on the market

91

END

92

What are the 12 Deregulatory Steps to Financial Meltdown?

The 12 slides will discuss the 12 events which resulted in the financial collapse of 2007 to 2008 as explained in Sold Out of March 2009 http://www.wallstreetwatch.org

93

#1 Repeal of theGlass-Steagal Act

The Financial Services Modernization Act of 1999 formally repealed the Glass-Steagal Act of 1932

94

#2 Hiding Liabilities: Off Balance Sheet AccountingThe Financial Accounting

Standards Board allowed securitized mortgages to be held as an off-balance sheet entity so that banks did not have to have capital reserves to secure the pool of loans

95

#3 The Executive Branch Rejects Financial

Derivative RegulationBrooksley Born was relieved of

her duties and the Commodity Futures Trading Commission was instructed to cease any activities over the derivatives market, as well as states

96

#4 Congress Blocks Financial Derivative

Regulation

The Commodities Futures Modernization Act of 2000 exempted financial derivatives from regulation

97

#5 The SECs allowed Banks to set their own reserve requirements

In 2004 the SEC authorized investment banks to develop their own net capital requirements, this resulted in excessive leverage with ratios as high as 40 to 1

98

#6 Bank Self-Regulation Goes Global: Preparing Repeat of the Meltdown

The complicated financial maneuvering made it hard for international banks to agree and enforce any strict capital reserve requirements

99

#7 Failure to Protect Predatory Lending

Regulators sat on their hands when it came to protecting abusive behavior in the sub-prime mortgage market

100

#8 Federal Preemption of State Consumer

Protection LawsThe Office of the Comptroller of

the Currency issued formal opinions preempting all state predatory lending laws, thereby rendering them inoperative

101

#9 Escaping Accountability

Under existing federal law only the original mortgage lender is liable for any predatory and illegal features of a mortgage – even if the mortgage is transferred to another party

102

#10 Fannie Mae and Freddie Mac Enter the

Subprime MarketThe purchase of subprime

assets was a break from prior practice but was forced on these agencies by Congress in their attempt to make every American a home owner

103

#11 Merger ManiaThe abandonment of antitrust

related principles over the past has enabled a concentration in the banking sector resulting in megabanks with to-big-to-fail status with government guarantees against failure

104

#12 Rampant Conflicts of Interest: Credit

Rating Firm’s FailureThe credit ratings given by the

credit rating agencies were influenced by the fact that they got paid from the firms they rate resulting in the highest rating for CDOs based on the best mortgages in the pool

105

What is the Dodd-Frank Wall Street Reform and Protection Act of 2010?

An Act to promote the financial stability of the United States by improving accountability and transparency in the financial system, to end "too big to fail", to protect the American taxpayer by ending bailouts, to protect consumers from abusive financial services practices, and for other purposes

106

How long is the Dodd-Frank bill and what are

some highlights?2100 pages• New Consumer Protection Agency

tucked under the Federal Reserve• Establishes rigorous standards &

supervision for financial firms• Establishes council to identify

systemic risks

107

What is the Consumer Financial Protection Bureau as part of the

Dodd-Frank Bill?• Receives 10% of Fed’s assets but is

not under its jurisdiction• Led by an independent director• Able to autonomously write rules for

financial institutions• Ends the “shadow” financial system

by requiring hedge funds to register with the SEC and provide information about their trades

108

What is the Volcker Rule?

Implements regulations for banks, affiliates, and holding companies that prohibit proprietary trading, investments in hedge funds, and private equity funds

109

What is theShadow Banking System?

The financial intermediaries involved in facilitating the creation of credit across the global financial system, but whose members are not subject to regulatory oversight

110

What are some examples of Shadow Banking System?

Hedge funds Unlisted derivatives Credit default swaps hypothecation

111

What is Hypothecation?

When a person pledges a mortgage or other assets as collateral for a loan, it refers to the right that a banker has to liquidate goods if you fail to service a loan. You are said to "hypothecate" the mortgage when you pledge it as collateral for a loan

112

What is Rehypothecation?

The practice by banks and brokers of using, for their own purposes, assets that have been posted as collateral by their clients. Clients who permit rehypothecation of their collateral may be compensated either through a lower cost of borrowing or a rebate on fees

113

What is an example of Rehypothecation?

In a typical example of rehypothecation, securities that have been posted with a prime brokerage as collateral by a hedge fund are used by the brokerage to back its own transactions and trades

114

What is the status of Rehypothecation in America?

In the United States, rehypothecation of collateral by broker-dealers is limited to 140% of the loan amount to a client

115

What is the status of Re-hypothecation in the UK?

Unlimited rehypothecation is legal, this is called churning, 30 to1 leverage is common

116

What is Re-hypothecation in the UK an example of?

Unlimited leverage

117

What is the latest casualty of re-hypothecation?

John Corsign and MF Global collapse, 8th largest bankruptcy in America’s history

The following video is not required

http://rt.com/programs/capital-account/mf-global-banking-mafia/

118

Who could be the next casualty?JP Morgan has $500 billion in the hypothecation market and an off – balance sheet $90 trillion in derivatives. Every large financial institution has large sums of money in this market with liquidity backed by no assets

The following video is not requiredhttp://rt.com/programs/keiser-report/episode-223-max-keiser/

119

What do low interest rates have to do with hypothecation?

Financial firms can borrow money at close to zero interest rates and use the money to use in the hypothecation market using the same collateral over and over resulting in the world’s largest credit bubble

120

What is Moral Hazard?

In economic theory, a moral hazard is a situation where there is a tendency to take undue risks because the costs are not borne by the party taking the risk

121

Tell me more• YouTube  "Fear the Boom and Bust" a

Hayek vs. Keynes Rap Anthem

• YouTube  "Hayek's 'Road to Serfdom' in Five Minutes“

• YouTube "Senator Paul Ryan on the Rule of Man vs. the Rule of Law"